Unconstrained - All posts tagged Unconstrained

Everybody and his brother (and Bill Gross too) loves an unconstrained bond fund these days, and Calvert Investments is the latest to hop on that bandwagon, announcing today the launch of the Calvert Unconstrained Bond Fund (CUBAX). In short, unconstrained funds aren’t benchmarked against traditional bond indexes, like the Barclays Aggregate Index. Instead they offer managers hedge-fund style freedom to trade in and out of sectors and bonds as they please. In the last couple of years they’ve been pitched as way to minimize risk at a time when interest rates are supposed to rise and bonds could see losses like they did in the summer of 2013. (For the longer version, see my Barron’scover story on unconstrained funds from last October.)

In addition to the usual language about flexibility and providing returns during any market environment that typically accompanies the launch of these funds, Calvert calls this fund “the only mutual fund in the nontraditional bond category to feature the incorporation of environmental, social and governance (ESG) analysis in its investment process.” More from Calvert:

A unique aspect of Calvert’s sector and security selection process involves a relative value assessment of both fundamental and ESG risks. The credit team collaborates with in-house sustainability research analysts to find opportunities in industries and companies that exhibit a combination of particularly strong fundamentals and favorable ESG factors. They avoid exposure in areas of the credit market where the reverse may apply.

Separately, Western Asset today put out a report titled “A Decade of Unconstrained Investing” touting the 10-year anniversary of the firm’s Total Return Unconstrained strategy. Here are Western Asset’s Mark Lindbloom and Doug Wade looking to the years ahead:

Looking ahead, we expect US Treasury rates will eventually increase as the Fed continues to normalize monetary policy. The rally in global spread sectors has amplified the importance of fundamental analysis as true value opportunities are scarce. Western Asset’s TRU is a dynamic product that we believe is well equipped to meet these future market challenges. TRU has the duration and curve flexibility to fully express our views on interest rates and help protect the portfolio in a potential rising rate environment.

With the Fed poised to start hiking short-term rates in the next year or so, BlackRock sees interest rates becoming more volatile and says municipal bond investors should be looking to the same unconstrained-style fund strategies that have been gobbling up market share across the broader bond market. Peter Hayes, head of BlackRock’s muni bond group, says investors should be thankful for the big gains posted by munis so far this year, up 6% through July, but that “caution is warranted” at this point and investors should “protect those gains rather than reach for more.”

It’s a concept that’s just taking hold in the muni space, and we think it makes a lot of sense. Essentially, an unconstrained municipal strategy, such as our own Strategic Municipal Opportunities Fund (MAMTX), is a flexible, one-stop solution that invests across the entire municipal spectrum. It’s not limited to bonds of a particular credit quality or maturity date. Importantly, we are able to manage interest rate risk by adjusting our duration as needed in an effort to mitigate the losses that accompany a rise in interest rates. It’s a kind of flexibility not previously available, and we think it can add a lot of diversification to your muni allocation at a time when market uncertainty demands a high level of adaptability.

Fund management firms have been pitching unconstrained strategies as solutions to bond investing at a time when rates are expected to rise, and unconstrained funds have surged in popularity in the wake of the spike in bond yields during May and June 2013. As I wrote in my Barron’scover story last October, these funds can make sense as complementary holdings to traditional bond funds, but investors need to keep an eye on what these funds hold, since they can move in and out of investments quickly and frequently, and one firm’s unconstrained strategy can bear little resemblance to another’s. BlackRock’s flexible muni fund is up 7.56% so far this year.

Firms keep adding unconstrained bond funds to their mutual fund offerings, and the newest addition to the unconstrained bandwagon comes from Schroders, which today announced the launch of the Schroder Global Strategic Bond Fund (SGBNX). Schroders calls it “an actively managed portfolio with the flexibility to invest in the best opportunities throughout the fixed income universe” that “offers investors the potential for total return in different market environments—including periods of rising rates.” Schroders also announced the launch of the Schroder Global Multi-Asset Income Fund (SGMNX), which Schroders calls “a diversified portfolio that seeks to maximize income and manage volatility by investing directly into both equities and fixed income securities around the globe.”

As I’ve written before (particularly in my Barron’scover story on unconstrained funds last October), unconstrained funds don’t tether themselves to traditional benchmark bond indexes (namely the Barclays Agg) that govern most “core” bond funds and effectively require them to hold certain percentage of Treasuries and mortgage bonds, which are highly susceptible to interest-rate risk. In the past year investors have flocked to alternative fund that claims to protect against rate risk but the tricky part is keeping track of what these funds hold at any time and whether they expose investors to other risks and heightened equity correlation. Hence they’re best used as complements to traditional bond funds rather than replacements.

Schroders offers a thorough explanation of the fund’s mandate in its prospectus, which serves as a pretty good primer on how broadly flexible unconstrained funds are in general. Here’s an excerpt:

The Fund invests primarily in securities of issuers located in a number of countries around the world, including emerging markets and the United States…. The Fund may invest in securities rated in any rating category and in unrated securities, and it may invest any portion of its assets in securities rated below investment grade or in unrated securities considered by the Fund’s advisers to be of comparable quality (so-called “junk bonds”). In addition, the Fund may invest a majority of its assets in asset-backed and mortgage-backed securities.

Unconstrained by design, the portfolio is not managed with reference to a specific benchmark. The Fund’s advisers will allocate the Fund’s assets among issuers, types of securities, industries, interest rates, and geographical regions based on an assessment of the relative values and the risks and rewards these potential investments present. The allocation of the Fund’s assets to different sectors and issuers will change over time, sometimes rapidly, and the Fund may invest without limit in a single sector or a small number of sectors of the fixed income universe. The average duration of the Fund will vary based on the advisers’ forecast for interest rates, and there are no limits on the Fund’s portfolio duration or average maturity….

The advisers may use derivatives actively in managing the Fund, including without limitation, foreign currency exchange transactions (including currency futures, forwards, and option transactions), swap contracts (including interest rate swaps, total return swaps, and credit default swaps), futures contracts and options on futures…. The Fund may implement short positions, including through the use of derivative instruments, such as swaps or futures, or through short sales of instruments that are eligible investments for the Fund.

DoubleLine founder Jeffrey Gundlach hosted a webcast today to discuss the firm’s two newest funds, the DoubleLine Flexible Income Fund (DFLEX) and the DoubleLine Low Duration Emerging Markets Fixed Income Fund (DBLLX), both designed generally to offer healthy yields while minimizing interest-rate risk. He spent most of the time talking about the flexible fund, which marked an about-face for such a previously outspoken critic of so-called unconstrained bond funds. Without ever using the word “unconstrained,” Gundlach said he hopes to differentiate this fund from similar go-anywhere funds by keeping investors apprised if it makes any big changes in its holdings.

“One of the things I don’t like about highly active funds is that investors don’t know what they’re in,” Gundlach said, adding that the fund wants to be “very transparent ” so it “isn’t just a blind pool where investors don’t know what’s happening.” Still, he said the fund is “designed to mutate according to market conditions” and that its titular flexibility lets it go negative on duration by using short positions if it wants. “We know that many investors are worried about interest rate risk,” he said and it’s “hard to argue” that interest rates won’t move higher over time. At the moment, he said the fund is long-only and doesn’t own any Treasury bonds.

Gundlach parried some skeptical questions at the end of the webcast, such as one asking why this fund seems similar to products offered by competitors years ago, to which Gundlach basically said that you can’t always rush these things, noting that the fund is based on a strategy DoubleLine has already been implementing for institutional clients for the past couple of years. To another listener asking if these new new offerings stretch DoubleLine too thin, he replied “Hardly,” even if he “can sympathize” with the idea that investors can sometimes face too much choice. He said there are no plans for other new DoubleLine funds on the drawing board except potentially a non-dollar-denominated international bond fund.

If you haven’t yet, check out the Investing In Funds & ETFs section of today’s Wall Street Journal, in which you’ll find a trio of articles about bond investing, The first story, by Tom Lauricella, is the latest look at the risks and rewards of unconstrained bond funds. It lists the top five such funds based on net inflows over the year ended Jan. 31, including four of the five funds I wrote about in my Barron’scover story last October. The gist:

Most unconstrained bond funds replace interest-rate risk with corporate credit risk, which can make their portfolios behave more like stocks. They sometimes shift their holdings dramatically, which can make it difficult for investors to assess how they will fit into a portfolio. Many are chockablock with complicated derivatives. And they typically charge much higher fees than traditional bond funds.

Managing Director Darell Krasnoff says Bel Air Investment Advisors uses an unconstrained bond fund for some clients, but as a hedge-fund-like holding, not a core bond investment.

“People will be surprised at the volatility and the range of returns of what can happen with these unconstrained funds,” Mr. Krasnoff says. “We don’t think it’s wise to think about generating higher returns than with core bond funds and assume you’re not taking more risk.”

The second story, by Chris Gay, discusses how the current yield of the 10-year Treasury note might be the best barometer of what your bond investments are going to return over the next decade, which sounds intuitive enough but serves as a helpful reminder for investors who tend to look to past results as predictors of future returns, despite all the fine print of asset management industry advertising.

The third story, by Corrie Driebusch, looks at some of the hottest new bond funds of last year, including a muni fund, a corporate bond fund, and a couple of bank-loan funds.

Add Neuberger Berman to the growing list of big investment houses that want in on the unconstrained bond fund craze. Neuberger today announced the launch of the Neuberger Berman Unconstrained Bond Fund (tickers NUBAX, NUBCX, NUBIX, and NRUBX), which the firm calls “an absolute return oriented global strategy that utilizes a broad set of tools to take advantage of market mispricing.”

To recap: “unconstrained” is a catch-all category of bond funds whose broad mandates free them from traditional benchmark bond indices, namely the Barclays Agg. Those indices, and the funds that follow them, tend to be laden with Treasuries and mortgage bonds and thus heavily exposed to the type of interest-rate risk that hurt bonds last year and undercut many core-style funds. In practice, unconstrained funds tend to dial up credit risk and dial down duration, or interest-rate risk, by focusing on shorter-dated, lower-rated bonds. The trick is that such funds can vary significantly from one another in their holdings and their approaches.

Some see unconstrained strategies as the way forward for bond investing in a broadly rising-rate environment, with unconstrained funds serving to complement core-style funds. Others see unconstrained strategies as counter to some of the main purposes of bond investing (like maintaining a low correlation to stocks) and, at this point, like closing the barn door after your bond fund already lost 2% last year. But as bond funds broadly saw outflows last year, unconstrained funds took in 30% more last year than they did in 2012, so why not give investors what they seem to want.

Neuberger says the new fund can take both long and short positions in bonds. More from Neuberger:

The full global credit and securitized spectrum will be utilized and the fund will have complete duration flexibility with the ability to have positive, negative or zero duration. The Fund will be unconstrained by benchmark (US T-bill index) as its managers seek to capitalize on best opportunities worldwide.

“U.S. investors are re-evaluating their fixed income exposures as a traditional benchmark-driven long-only approach comprised primarily of domestic investment-grade bonds may no longer fully meet their objective of stable income with low risk to principal,” said Brad Tank, Neuberger Berman’s chief investment officer for fixed income. “We believe Neuberger Berman is in a unique position to introduce an unconstrained bond strategy in a mutual fund structure for U.S. investors, as we have specialist sector teams covering the full breadth of the global fixed income universe and a proven process that the Fund’s managers will employ to take advantage of market mispricings and allocate risk across global rates, currencies and credit. This fund takes a place among our current fixed income strategies including Short Duration, Core and Strategic Income and others.”

If you can’t beat ‘em, join ‘em. DoubleLine just filed paperwork with the SEC today to launch the DoubleLine Flexible Income Fund, an unconstrained-style bond fund. From the prospectus:

The Fund seeks current income and capital appreciation by active asset allocation among market sectors in the fixed income universe. These sectors may include, for example, U.S. Government securities, corporate debt securities, mortgage and asset backed securities, foreign debt securities, including emerging market debt securities, loans, and high yield debt securities. The Adviser has broad flexibility to use various investment strategies and to invest in a wide variety of fixed income instruments that the Adviser believes offer the potential for current income, capital appreciation, or both. The Fund is not constrained by management against any index.

Note those two words: “not constrained.” Why are they significant? Because they identify the fund as an unconstrained-style fund, a loosely defined bond-fund category that’s exploded in popularity lately after being marketed as a way to dodge interest-rate risk. As I wrote in my Barron’scover story in October, unconstrained funds can be all over the map in terms of what they own, but what unites the category is the ability to eschew traditional bond index benchmarks, offering managers broad investing flexibility, and their strategies have tended toward shortening duration and lowering credit quality.

This marks a big departure from what DoubleLine founder Jeffrey Gundlach - who will manage the new fund – has previously said about unconstrained funds, which is basically that he doesn’t like them. Here’s what he told me during a conversation four months ago:

“Unconstrained funds are popular because people don’t know what they are. They think what bond funds used to do isn’t going to work, so now the holy grail is to show me a bond fund that doesn’t have any interest-rate risk but somehow has return. Unconstrained funds actually have more risk than total return funds or core funds because they have more aggressive investments.”

“Measured against an index you become more of a security selector. If you’re good at that, then you can have the same broad statistical exposure to bonds, like the same duration and you can monitor the yield and so on, but you’re buying mispricings in the market, and you have a confidence about performing that way. When it comes to an unconstrained fund, thematically, if they’re approached the way they’re marketed, they’re kind of macro funds.”

Gundlach’s flagship DoubleLine Total Retun Fund (DLTNX) has grown to $32 billion since its inception less than four years ago and has consistently been a top performer in its category. The new fund’s launch comes as unconstrained funds are growing in popularity while total return-style funds have struggled to stem investor outflows after many lost money in 2013.

A DoubleLine spokesman declined to comment further, citing the quiet period while the SEC reviews the filing. Here’s more from the new fund’s prospectus:

The Adviser expects to allocate the Fund’s assets in response to changing market, economic, and political factors and events that the Fund’s portfolio manager believe may affect the values of the Fund’s investments. The allocation of the Fund’s assets to different sectors and issuers will change over time, sometimes rapidly, and the Fund may invest without limit in a single sector or a small number of sectors of the fixed income universe. The Fund may invest in securities of any credit quality.

We checked in recently with Mark Cernicky, a managing director at Principal Global Investors, which has $73 billion in fixed-income assets under management. His basic advice for bond investors in 2014: expand your allocation to corporate bonds, shorten your duration and look to Europe.

Cernicky thinks rates will rise gradually this year, with the ten-year Treasury yield ending the year somewhere between 3.25% and 3.5%. He expects an eventual flattening of the long end of the yield curve, between 10 and 30 years, partly thanks to strong demand for longer-dated bonds from pension funds, and he currently sees a “pretty steep” front end of the curve. “Somewhere in the one- to five-year space there’s significant value to owning debt and rolling down that yield curve,” he says.

He prefers short duration high-yield bonds to bank loans, which saw record inflows last year but still underperformed high yield. “Our view is that defaults are going to remain low and that there’s better value in one- to five-year bonds than in loans,” he says, pointing out most junk bonds have call protections while loans can be repriced at any time.

In Europe, he sees some incipient growth to go with more accommodative monetary policy by the ECB, which means less interest-rate volatility than the U.S. might see this year, and he says many European companies that have historically borrowed from banks are raising bond debt instead. He currently likes non-cyclical high-yield companies, particularly in the wireless sector, as well as metals and mining companies. He sees improvement ahead for Spain and Italy but is bearish on France, saying French President Francois Hollande’s economic policies “don’t look like they’re working very well.”

He likes Russia and Mexico but is generally avoiding emerging market debt, even though it’s cheaper following last year’s selloff. “Flows have been negative, and commodity prices are lower,” he says. “EM debt trades with a higher beta to US Treasury rates, and I think we’re going to see higher rates in some countries.”

Cernicky counts himself in the camp of so-called unconstrained strategies that look to minimize the interest-rate risk inherent in benchmark indexes like the Barclays Aggregate index, known as the Agg. “We do think of ourselves as an alternative strategy,” he says. “Higher rates will cause some pain for Agg strategies. We try to reduce allocation to Treasuries and mortgage bonds and have a higher credit allocation.”

My Barron’s cover story two months ago examined the surging popularity of so-called unconstrained bond funds this year, noting that the unconstrained moniker is really a catch-all category for funds that eschew traditional benchmark indexes but can vary tremendously from one to the next, with the common theme this year being a desire to minimize interest-rate risk.

Today the Wall Street Journal offers its own look at such funds, saying investors have already poured $70 billion into U.S. unconstrained funds through October, a 30% increase from all of 2012, while European funds saw $27 billion in net inflows in the first nine months of 2013, up from $18 billion for all of 2012, per Lipper data. Beyond looking at the same Pimco and JP Morgan strategies profiled in the Barron’s story, the Journal calls out one of this year’s biggest losers, which not surprisingly made big bets in emerging-market debt, which had a pretty terrible year. Ben Edwards and Nick Cawley report:

While unconstrained bond funds try to offer protection against rising rates, they are prone to other pitfalls. About a third of flexible bond funds that Morningstar tracks are in negative territory this year, with those that mostly invest in emerging-market debt are among the hardest hit.

“The fund is focused exclusively on emerging-market debt strategies, and it has been a difficult year for the asset class,” said Henry Stipp, co-head of emerging markets at Threadneedle, which has about £84.9 billion ($138.97 billion) under management. “Our exposures to local bonds and currencies have negatively impacted performance thus far in 2013.”

Again, if you believe interest rates are going to rise further, these funds can help dodge some of the interest-rate risk inherent in core bond funds. But if you’re investing in an unconstrained fund make sure you look under the hood, because they can look completely different from one another and can ramp up credit risk and other risks to boost returns.

Amey Stone is Barron’s Income Investing blogger and Current Yield columnist. She was formerly a managing editor at CBS MoneyWatch, MSN Money and AOL DailyFinance. Her responsibilities included overseeing market coverage and personal finance topics. Prior to those roles, she was a senior writer at BusinessWeek where she authored the Street Wise column online and contributed to the magazine’s Inside Wall Street column. Topics covered included economics, corporate finance, Fed policy, municipal bonds, mutual funds and dividend investing. She co-authored King of Capital, a biography of Citigroup Chairman Sandy Weill. She is a graduate of Yale University and Columbia University’s Graduate School of Journalism.